"The Market's Down, Not Doomed"
Barron's: Let's start with the big picture.
Cooperman: We acknowledge that we were somewhat too optimistic about the year. And we basically pressed that optimism in March during the selloff when we largely took off all our hedges. We based that on an old tried-and-true — and tested — approach. We have found historically that when the S&P dropped 20%, which it did from its October peak to its March low, when the Fed and Congress were stimulating [the economy], when you are in an election year, when stocks are undervalued versus bonds and when stocks are somewhat cheaper versus their own history, you are supposed to buy. Basically, every time we went through one of these cycles, there was a vocal minority that said it was different this time. In 1970, for instance, when I was at Goldman, everyone who was negative at the bottom talked about the Penn Central bankruptcy. Thankfully for the system, after each one of those cycles, it wasn't different. The economy got itself together and we started anew. That was our view in March.
What's surprised you, subsequent to March?
Cooperman: Oil getting to $140 a barrel and the degree of weakness in housing was much more diverse, widespread and severe than anything we've seen. And the credit crunch turned out to be much more of a problem than we could have imagined. More of that problem migrated from Wall Street to Main Street than we allowed for.
Where does the market go from here?
Cooperman: The ingredients for a decent bottom are in place, but any significant upside is going to require help from two areas. No. 1, we have to see a bottoming in home prices. No. 2, we are going to have to see crude-oil prices recede. Frankly, we didn't forecast crude going to $140 a barrel, so we aren't confident forecasting that crude is going to $100. In fact, we have two energy experts, and neither believes crude is going much below $120.
Einhorn: The market is protected on the downside by some tail winds that I will elaborate on. But the market is limited on the upside because of housing and crude prices, among other head winds. So it will trade in a range until we can make progress on crude and home prices. As for crude, most of the models indicate that every $10 price increase is worth about two-tenths of a percent of real GDP growth. So if the price goes up $40, it almost costs you a full percentage point of growth in the economy, and it probably costs between $4 and $5 in S&P earnings.
Why do you think that we're close to a bottom?
Einhorn: Because there are certain tail winds, the first of which is valuation, that protect the market. The market looks attractively priced in an absolute sense and relative to inflation, bond interest rates and to other assets.
What is your price/earnings ratio for the market?
Einhorn: We have a market earnings estimate this year of $90 and next year of anywhere from $92 to $100, and we'll refine that as the year unfolds. That's roughly 14 times this year's earnings, below the long-term average. At the same time, bond interest rates are low, return on equity is well above average and net profit margins are well above average. So the absolute multiple is below average, and corporate profitability, liquidity and balance-sheet strength in the nonfinancial sectors are well above average. Based on virtually any approach, the market is attractively priced. I think it is already discounting a substantial shortfall in consensus earnings estimates.
What other tail winds do you see?
Einhorn: We aren't expecting the economy to be robust. But at least for now, the economy's weakness isn't accelerating, as it typically does in more significant recessions. Another tail wind is that in early 2009, whoever is elected president will introduce a second fiscal stimulus package, most likely larger than the last one, to underpin the economy. Another thing to consider — and it's been overlooked — is that nonfinancial sector earnings have been above consensus. They may weaken, but so far nonfinancial S&P companies have reported a 10% improvement in earnings, year-over-year. There's also plenty of investor liquidity. There's also the Fed. Given the deleveraging going on in the financial sector and that financial stocks are trading close to their cyclical lows, it's very difficult to imagine the Fed lifting interest rates.
A friendly Fed is an important tail wind that will create excess liquidity in the system, steepen the yield curve and improve bank profitability, which at some point is necessary to begin to rebuild capital. And there is investor sentiment, which is pretty negative. Typically, when sentiment is negative, the market tends to do better.
Read the complete interview here, if you have interest.
-- David M Gordon / The Deipnosophist